Question

Suppose you observe the following effective annual zero-coupon bond yields: 4.39% (1-year), 5.05% (2-year), 5.66% (3-year). Compute r 0(1,2), the 1-year implied forward rate for year 2.

Answer= 5.71% How to solve? Thanks

Answer 1

Calculate the forward rate as follows:

Forward rate for year 2, r(1,2) = ((1 + Year 2 interest rate)^2 / (1+ Year 1 interest rate)) - 1

Forward rate for year 2, r(1,2) = ((1 + 5.05%)^2 / (1+ 4.39%)) - 1

Forward rate for year 2, r(1,2) =1.0571 - 1

Forward rate for year 2,r(1,2) = 0.0571 or 5.71%

Therefore, the forward rate for year 2 is 5.71%.